CROSS-ELASTICITY
Definition
Cross-price elasticity measures the sensitivity of demand for product A to a change in the price of product B. It reflects the economic relationships between products: substitutes (Coca-Cola/Pepsi), complements (printer/ink cartridge), or independent products. It is an essential concept for managing a product assortment consistently and avoiding pricing decisions that cancel each other out at the category level.
Why it's important
- Avoiding cannibalization: Lowering the price of one product can hurt sales of another; cross-price elasticity predicts this.
- Optimizing promotions: Promoting a product that has high-margin complementary items can create a positive ripple effect.
- Managing the product mix: Understanding the relationships between products allows you to structure a pricing policy at the category level, not just by individual SKU.
A concrete example
A supermarket lowers the price of a brand of beer from €1.99 to €1.69 (-15%). Sales of this beer increase by 35%. However, sales of two competing brands in the same aisle drop by 12% and 18%, respectively. Cross-elasticity is positive (substitute products). At the category level, beer revenue increases by only 3%, while the average unit margin decreases by 8%. The promotion therefore erodes the total margin.
How to measure/use it
Cross-price elasticity is measured using multivariate econometric models that isolate the effect of the price of B on sales of A, while controlling for other variables (seasonality, competitor promotions). A positive cross-price elasticity indicates substitute products, while a negative value indicates complementary products. Pricing analytics tools automatically calculate these elasticity matrices at the product mix level and enable the simulation of the impact of a pricing decision on all related products.
Common Mistakes
- Thinking on a product-by-product basis: Optimizing each individual product can undermine value at the category level.
- Ignore non-branded substitutes: a private label can cannibalize a national brand, and vice versa.
- Underestimating complementary products: forgetting that lower pasta prices boost sauce sales, and vice versa.
Learn more
- Research & Data: Basketball analysis and cross-elasticity matrices by category.
- Solutions: Pricing Analytics to incorporate cross-price elasticities into pricing recommendations.
- Tip: Develop a pricing strategy at the category level to prevent cannibalization.
- Resources: Check out our pricing FAQ to learn more about intra-category cannibalization.